Environmental Uncertainty and the Market Pricing of Earnings Smoothness

Abstract

Organization’s environmental uncertainty induces greater variability in reported earnings, and accentuates the information asymmetry between managers and outside stakeholders. Managers have the incentives to reduce such variability via income smoothing and hence reduce information asymmetry for firms operating in highly uncertain environment to maximize the stock price. This paper measures income smoothing by the negative correlation of a firm’s change in discretionary accruals with its change in pre-manages earnings as per Tucker and Zarowin (2006). Using future earnings response coefficient (FERC) methodology to measure the informativeness of smoothed earnings, this paper documents that current stock price incorporates more information about future earnings for firms operating in highly uncertain environment proxied by both the coefficient of variation of sales and the dispersion of financial analysts’ earnings forecasts.

Keywords: Environmental uncertainty, income smoothing, future earnings response coefficients

JEL Classification: M43, M40